When Are Nonshareholder Capital Contributions Tax-Free? (article)

The IRS and the courts have sparred with taxpayers over the taxation of nonshareholder contributions to capital since the dawn of our “modern” tax system in 1913. Over the years, courts at all levels sought to define when such contributions may be excluded from income, with inconsistent results. Conflicting IRS guidance also led some to question whether partnerships could take advantage of the income exclusion benefit (a provision thought to be unavailable to partnerships).

The matter is more prevalent in recent times, with federal and state financial assistance provided frequently to entities of all types in the form of stimulus packages, grants and incentives. Corporations have the ability to benefit from the income exclusion for financial support they receive, whereas partnerships seemingly do not.

Defining Contributions to Capital

Early court cases pressed the question on whether corporations may exempt capital contributions from income when the contributions are made by nonshareholders. In Brown Shoe Co., Inc. v. Commissioner, the U.S. Supreme Court ruled that private contributions made to a shoe manufacturer to entice the manufacturer to establish operations in a particular location could be excluded from income. The court reasoned that the contributions held a community benefit and also permitted the taxpayer to include the amount of the capital contributions in its depreciable tax basis. In Chicago, Burlington & Quincy R.R. Co. v. Commissioner, the Supreme Court later established five characteristics a nonshareholder contribution to capital must have to make it exempt from income:

The payment becomes a permanent part of the corporation’s working capital;

The payment does not reflect compensation for a service performed for the corporation;

The payment is bargained for;

Any assets accompanying the payment must benefit the transferee in an amount commensurate with the valuation of the assets; and

The asset must ordinarily be employed in the production of additional income.

Allowing the taxpayer to include the amount of capital contributions in its depreciable tax basis could produce a double benefit for the taxpayer. Congress addressed the issue with the enactment of Code Sections 118 and 362. Code Section 118 clarified that qualifying contributions to capital from nonshareholders would be excluded from a corporation’s income. Code Section 362 established that property acquired by a corporation that is treated as nontaxable under Code Section 118 would not result in any depreciable tax basis.

In subsequent cases, courts would continue to focus on nuances of the five characteristics to determine whether a capital contribution qualified for income exclusion under Code Section 118.

Section 118 and Partnerships

By its own terms, Code Section 118 applies to corporations, but early on, the IRS indicated to taxpayers a willingness to extend the income exclusion benefits to partnerships. In a case involving a public utility company, the IRS used a two-part test to determine whether the public utility company could claim the income exclusion. The IRS analyzed the intent of the contribution, together with the effect of the contribution on the partnership. In this early instance, the IRS ruled that if the contribution was intended to provide a community benefit, then the exclusion would apply. The IRS reversed its position through later rulings, holding that the Code Section 118 income exclusion provision applied only to corporations.

More recent IRS guidance in 2007 confirms that Code Section 118 applies only to corporations. If an entity anticipates receiving financial incentives from a federal or state governmental agency (or from any other nonshareholder), it might consider an S corporation structure. The pass-through benefits of S corporations are similar to those of a partnership, but the corporate status would allow the S corporation to take advantage of Code Section 118.

Although Code Section 118 remains out of reach to partnerships, other forms of financial assistance from federal and state governments may circumvent the need to rely on it. IRS guidance in 2008 indicates that tax incentives (specifically, “location tax incentives”) are nontaxable to the recipient under general tax principles. Such incentives are offered to persuade a business to move or expand its operations into a desired location through tax rate reductions, tax credits and abatements, special income exemptions, property tax exemptions and targeted jobs credits. Any taxpayer (including partnerships) should exclude such tax incentives from income, according to the IRS.

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